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The Long and Short of It

I'm thinking about starting a hedge fund, which will permit me to sell stocks short, so I am networking like crazy in an effort to do it right. I sheepishly tell people that I'm a plain-vanilla guy who rarely sells short -- that is, bets on a stock's price to fall -- as the sexiest hedge funds do.

I'm surprised by the tenor of the comments I hear. Many of my broker and hedge fund pals denigrate short-selling. "Nobody makes money shorting," says a man who provides hedge funds with seed capital. An executive at a fund that invests in other hedge funds says: "Investors like to see that a manager offers short-side protection. But funds make almost all their money on the long side."

In theory, short-selling sounds like a breeze. When A.W. Jones started the first hedge fund in 1949, his mission was to buy good stocks and short bad ones. What could be simpler and more logical? It turns out, though, that lots of great investors have come to grief shorting stocks. According to one of my sources, the hedge fund run by the nation's best-known short seller, James Chanos, of Kynikos Associates, returned 2% annualized after fees from 1985 through 2005. On the one hand, you could argue that's impressive performance considering that the stock market compounded at a 13%-a-year clip during the period. On the other, 2% is chump change. (I mean no disrespect to Chanos, who is a bright man, but I am reminded of Samuel Johnson's comment that "a horse that can count to ten is a remarkable horse, not a remarkable mathematician.")

I should add that, as a short seller, I am not even a remarkable horse. Over time, my return shorting stocks has been about 0%. Be still my heart.

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The hardest thing about shorting is this: Stocks rise relentlessly over the long haul. That's a powerful current to swim against. "Hey, why bother?" says my hedge fund friend Sam, who has shorted stocks for decades but is doing much less shorting now.

Other factors conspire against successful shorting:

Hype. Supporters of a stock often flog its story energetically, causing shares of even nearly worthless companies to levitate. As a stock rises, more people learn about the story -- and propel the stock even higher. A shrewd short seller can be right about a company ultimately ending up on the ash heap but be painfully wrong about the timing of the stock's demise. When a stock you've shorted doubles or triples, it's torture to stay short -- and hard to stay solvent.

Fear. Because everyone who bets on a stock to fall worries so much about this melt-up scenario, short sellers often operate with tight stop-loss limits. That, ironically, hurts their results. My buddy Sam usually covers a short if the stock rises 5%. But he'd never sell a stock he just bought because it fell 5%. In fact, he might buy more. So fear leads some short sellers to seek instant gratification, which the market seldom delivers.

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Limited upside. Assuming no use of leverage, the most a short seller can make is 100%. That happens if the stock goes to zero. One financial publication called James Chanos's Enron short "the market call of the decade, if not the past 50 years." But millions of investors have made much bigger killings simply by investing the old fashioned way -- that is, buying stocks. Bragging rights aside, wouldn't you rather have backed up the truck on the Google IPO, as Bill Miller did, than have shorted Enron at $70?

So, some long-only investors argue, even when you're right about a short, you don't get paid enough for your brilliance. And when you're wrong, they carry you out in a box. All in all, it probably isn't worth it for most investors -- unless we're in the midst of an ugly bear market or you're an especially gifted horse.